3549: [Part 1] How I Measure Progress Toward Financial Independence by Craig Stephens of Retire Before Dad

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[00:00:47] This is Optimal Finance Daily, How I Measure Progress Towards Financial Independence, Part 1 by Craig Stephens of RetireBeforeDad.com.

[00:01:02] This article is about how I measure progress towards financial independence, which I consider a prerequisite to my early retirement goal. The terms financial independence and early retirement are often used interchangeably, but I consider them different. Financial independence is a financial milestone.

[00:01:21] Retirement is when I'll stop working completely. I plan to reach financial independence before early retirement. That's my own fiber movement, not to be confused with the fire movement.

[00:01:33] Financial independence is achieved by 1. Building enough passive income to cover annual expenses. Or 2. Building a lump sum of savings and investments, the fine number, to cover living expenses in perpetuity. Or 3. Some combination of number 1 and number 2.

[00:01:52] Using passive income involves building a portfolio of real estate, business income, or other income streams to cover living expenses. Ideally, these income streams are outside of retirement accounts, so they're easily accessible before age 59 and a half. The fine number is about building a lump sum of money that equals 25 times your annual expenses. So if you spend $60,000 per year, your fine number is 1.5 million.

[00:02:22] In the calculation of my financial independence number, I use a combination of both the amount earned through sustainable passive income streams and the lump sum of all of our retirement accounts. Why I started measuring my financial independence number. When I devised the fiber movement, I realized that I didn't have a financial independence number or a retirement savings goal.

[00:02:46] Early retirement for me is the point when I will stop working for good. No side business, no consulting, no moonlighting at Costco for health insurance, nada. My early retirement goal is age 55. That's an age, not a lump sum of money. When I reach financial independence, I plan to keep working. I intend to be fully ready to retire both mentally and financially by age 55.

[00:03:12] But the viability of that plan needs to be validated with numbers beyond my forward 12-month investment income calculation. That number doesn't account for savings in my retirement accounts. I track investment income, also known as passive income or forward 12-month investment income, meticulously every quarter. But my quarterly reports only include taxable investments.

[00:03:37] It has nothing to do with our retirement savings in my employer-sponsored 403b and several IRAs, which make up the bulk of our net worth. In order to know when we've reached financial independence, I need to measure all the relevant numbers. The phi number. The phi number is based on a study done back in the 1990s called the Trinity Study regarding safe withdrawal rates from retirement savings. This is commonly referred to as the 4% rule, of thumb.

[00:04:07] The math says, in general, and after a slew of assumptions, adjustments, and simulations, that if a properly invested retiree spends just 4% or less of their total retirement nest egg per year, they can draw down their savings at their current spending rate, adjusted for inflation, for 30 years before they run out of money. This works great if you retire at 65, because you'll have enough to live until 95, which covers most people.

[00:04:36] Early retirees aiming to retire under the age of 60 or much younger utilize the rule of thumb to declare financial independence. But if a 40-something retires using the 4% rule, 30 years of spending money may not be enough. And it assumes spending stays the same, only rising with inflation. It may very well increase due to unforeseen circumstances. However, there are many solutions to help you outlive your savings beyond 30 years,

[00:05:07] including spending less than 4% per year, earning a higher rate of return than the assumption, saving more than 25 times your annual expenses, earning some other kind of supplemental income, and creating sustainable income streams from which the principal is not withdrawn. Over a 30-year period, positive additions to any of these factors goes a long way, extending the longevity of the retirement nest egg.

[00:05:34] You often see young people on popular online news outlets claiming to be retired young and confidently. The reason they so confidently retire is the exhaustive research and testing that's been done on the merits of the 4% rule. With thousands of variables and endless scenarios, the 4% rule has been tested, retested, challenged, strengthened, weakened, and counter-argued to death. Perhaps because people stake much of their financial future on the concept.

[00:06:04] All you need to know is it's fine as a rule of thumb, but I'm not staking my entire financial future on it. Why I combine passive income and my FI number. The math and backtesting of the 4% rule are sound, and it's especially effective if the early retiree aims to create a bit of wiggle room to account for sequence of returns risk. Sequence of returns risk is essentially the risk that the stock market will tank shortly after retiring.

[00:06:34] For example, if you need $1.6 million to retire, you'd hate to see the market fall 30% the year after you call it quits. You'd only have $1.12 million left for the next 29 years. Even so, for 95% or more of the 30-year periods dating back to the 1920s, the math still works. Anyways, my strategy goes a step beyond saving a lump sum and withdrawing that money for the rest of my life.

[00:07:03] I create sustainable income streams through investing. Instead of drawing down the principle of these investments, I plan to let them ride well into retirement and perhaps to my deathbed. If I can create enough investment income that consistently grows above the rate of inflation and covers a solid portion of my living expenses, I can tap less of my retirement savings and reduce sequence of return risk.

[00:07:30] Retirement savings will continue to grow tax-deferred for longer, compounding into a more sizable nest egg. I hope to use that money for luxury travel in my old age, but it's also marked to cover health expenses, assisted living needs, family in need, and to leave to my family after I'm gone. The more sustainable income streams you can create, lowering your FI number, the faster your retirement savings will lead you to financial independence.

[00:07:58] The main point of today's article is to show how I calculate my FI number after accounting for taxable passive income. How I measure progress towards financial independence. Now that that's out of the way, let's get to the calculation. I'm not going to share our personal numbers because I don't share my net worth or annual spending. So I'm using dummy numbers to illustrate what I'm doing with my own numbers. A note on terminology.

[00:08:26] I'm using the terms passive income, investment income, sustainable income streams, forward dividends, and forward 12-month investment income, or F12MII, interchangeably in this article. The important thing to keep in mind is that the funds producing taxable investment income should be excluded from the FI number lump sum. To be continued.

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[00:11:18] While financial independence is a worthy goal, I also think working towards financial security can give you more flexibility and allow you to seize opportunities and navigate obstacles more easily. For example, when I discovered the FIRE movement at 28 years old, it motivated me to try and reach financial independence by 40 years old. And that's exactly what I started to do. I got out of 30,000 of debt in 11 months,

[00:11:45] then saved and invested 60% of my income for about 5 years. But then my circumstances changed, and I wanted to leave my job and give self-employment a try. A big drop in my income would have screwed up my timeline of reaching FIRE by 40, so it wasn't an easy decision. But I realized that the main reason I was pursuing FIRE was to gain full autonomy over my time, and I could have that through self-employment. So I took the leap,

[00:12:13] and I'm happy to report that I don't care if I reach FIRE by 40. Of course, I'm still saving and investing and living frugally. These behaviors are very ingrained, so I know I'll reach FIRE eventually, but I'm no longer overly focused on the goal. My life looks now how I would want it to if I was actually financially independent. So the goal has simply become irrelevant. Empower yourself to pursue goals, but stay open to what you're learning

[00:12:43] and the opportunities that present themselves along the way. But we're just halfway through the article now, so that'll do it for today. Thank you for being here, and be sure to come back tomorrow where we'll finish up this post and where your optimal life awaits. Thank you.